The Two Apples

Getty Images/Stephen Lam This is a post from Neil Cybart, an independent analyst covering Apple at Above Avalon. You can read additional analysis here. Sign up to receive his exclusive daily email containing Apple analysis and perspective here.

There are two Apples: AAPL, the stock, and Apple, the company.

While it would seem logical that one is merely a reflection of the other, in reality, the two are guided by vastly different parameters.

Over the long run, Apple and AAPL will likely be at odds with each other due to the very nature of Apple's long-term mission of making products that people love. It is the classic Wall Street vs. Silicon Valley battle, and 2015 was likely just a taste of what is to come.

AAPL's 2015

It would be an understatement to say that AAPL had a weak 2015. When looking at stock price performance, AAPL's underperformance was quite striking. While GOOG, FB, and AMZN saw strong double-digit stock price increases, AAPL reported a rare 3% decline, the first annual decline since 2008.

Even more striking, AAPL's performance meant that the market removed $46 billion of market cap from AAPL in 2015, whereas AMZN and GOOG were given nearly $350 billion of additional market capitalization. Exhibit 1 highlights the dramatic performance difference between AAPL and its large cap tech and mobile peers as well as the major indices.

Exhibit 1: AAPL Underperformance in 2015 Above Avalon

Apple's 2015

Even though AAPL shares recorded a remarkably weak year, Apple, the company, had a much more successful 2015. As it did in 2014, the Apple machine spent most of the year operating at full speed. In what should not come as much of a surprise, Apple updated the vast majority of its product line.

While Apple's services were said to have experienced more of a mixed bag in 2015, it is difficult to call Apple's new products flops. The Financial Times reported Apple Music having 10 million paying subscribers in six months, positioning the service well in its long-term goal of finding sustainability for the music industry. Meanwhile, Apple Pay saw a successful rollout in the U.K., although retailer support in the U.S. remains disappointing. New services such as Apple News were positioned as a way to keep users' attention hooked on Apple properties while using Apple gadgets.

However, the primary takeaway from Apple's 2015 wasn't related to any one particular product but rather the transformation Apple began to show in terms of embracing a new type of luxury. The ramifications from this change will likely play themselves out over the next 5-10 years. Once Apple began selling a $17,000 Apple Watch, the company was never going to look the same. This change will manifest itself in terms of Apple's ongoing quest to make technology even more personal.

Given all of these constructive long-term fundamentals, how did AAPL register such a weak 2015, underperforming its peers by a wide margin? AAPL, the stock, and Apple, the company are each guided by vastly different ideals and parameters.

AAPL: The Story

At a very fundamental level, a share of company stock provides an investor a way to own that company's balance sheet, including income-producing assets. The degree to which these assets can be utilized to generate future cash flows helps investors determine how much a share should be worth. With every investor having different expectations and required returns from a company, a stock's ultimate value is determined in the marketplace as the point at which demand for those shares (buyers) equals supply (sellers).

In 2015, the marketplace determined that Apple was worth $46 billion less at the end of the year compared to January 2, 2015.

Stories are important on Wall Street, and the story surrounding AAPL took a decidedly negative turn in 2015. While some will point to concerns surrounding slowing iPhone 6s and 6s Plus sales as leading to AAPL's first annual stock price decline in years, there are likely other, much more significant issues at pla y. Wall Street wants predictability or at least the appearance that things will be predictable in the future. AAPL has very rarely been able to give investors that sense of predictability. Just look at the sources of Apple's revenue over the past 15 years. Apple has gone from being the "iPod company" to the "iPhone company," and now there are genuine questions as to where the company goes from here.

Meanwhile, just as skepticism around AAPL began to take over, the stories developing around some of Apple's largest peers grew noticeably more optimistic in 2015. It should not be ignored that much of this renewed optimism surrounded founder-led companies: Alphabet, Facebook, and Amazon. For Alphabet and Facebook, the narrative switched to how the two companies are able to make money from giving away products for free, a strategy in which each party to the transaction is paying in different ways. For advertisers it is cash, while for users it is time and attention (not to mention data). Meanwhile, Amazon took the bear case surrounding its stock and flipped it on its head by purposely showing that Amazon could be much more profitable if management chose to be. Not to mention, the company is seeing sheer success in terms of e-commerce.

Where does AAPL fit into all of this? What is the narrative surrounding the stock on Wall Street? Apple is the company searching for the next big thing. There continues to be skepticism that management will be able to grow profits from hardware in a world being overtaken by software and cloud services. Investors are also showing a lack of confidence that iOS and Mac users will stay within the Apple ecosystem, paying for new services and buying new products. AAPL investors need confidence that Apple will be able to utilize its balance sheet to supply a particular level of cash flows in the future. The belief is that AAPL will have trouble maintaining its current success. Even though Apple may be strong today, Wall Street has concerns about the Apple of tomorrow.

Apple: Embracing the Unknown

Just as Wall Street is nervous about AAPL's changing revenue sources, Apple's ultimate success is built on that very ideal. Even though Apple was the "iPod company" yesterday and the "iPhone company" today, management's goal is to make sure that Apple will one day be known as something else, such as the "car company" or the "personal transport company." This isn't to suggest that Apple will change its culture and mission statement depending on where growth can be found. Instead, management looks to enter product categories that make it possible to advance Apple's goal of making technology more personal. In the beginning, such a goal was achieved with the Mac but soon included the iPod, then iPhone and iPad, and now Apple Watch. Exhibit 2 highlights Apple's changing revenue mix since 2002.

Exhibit 2: Apple Revenue Mix

When news broke that Apple was interested in designing its own electric car, reactions seemed to fall into two buckets. Some saw what had to be faulty reporting or a company that is unsure where to turn next in the face of slowing smartphone sales. Many seasoned tech industry watchers could not come to believe the thought of Apple, the maker of pocketable gadgets, designing a car. The "expanded CarPlay" narrative spread like wildfire, almost as a way to make sense of the Apple Car madness, even though that reasoning demonstrated a fundamental misunderstanding of Apple. Meanwhile, the other type of reaction was based more on how Apple actually looks at the world, searching for opportunities to rethink how things are done.

Apple management has one goal: make products that people love. The iPod met that goal just as the iPhone and iPad went on to do the same. Evidence is now pointing to the automobile industry as being ripe for Apple to place a big bet. Throughout 2015, we learned of Apple's developing interest in cars as Apple was meeting with contract manufacturers in Europe, talking with BMW, looking into autonomous testing centers, hiring automotive personnel, and of course, beginning to leave more subtle hints in interviews and keynotes. We saw the early signs of Apple laying out its future.

Meanwhile, there has been no denying that the Apple Watch was put through the expectations wringer in 2015. From being labeled as Apple's next big thing since iPhone, something Apple didn't do much to tamp down, expectations quickly did a 180 degree turn and focused on how the Apple Watch seemed like a flop. In reality, Apple's prior success altered the definition of a flop.

Apple's long-term success is based on not being afraid to embrace the unknown. The willingness to place big bets in industries outside their historical core competency is management's strategy for keeping Apple relevant.

The Divide

While AAPL investors look at changing revenue sources and Apple entering new industries as risk factors, for Apple such characteristics are normal business and according to plan. It is this divide that will likely continue indefinitely, suggesting it is unwise to expect AAPL to one day begin to follow Apple. Just as a declining AAPL stock price is no indication of a struggling Apple, there will likely come a time when AAPL outperforms peers even though Apple, the company, may be struggling.

One may ask if this type of divide between the two Apples exists with other companies. While it is is true that every stock is ultimately guided by different parameters as opposed to the company it represents, there are very few companies that are trying to follow Apple's strategy. Competitors may say they are interested in following the Apple path of keeping as many mistakes as possible in the design labs, leaving just a very few big bets for the public marketplace, but few practice the strategy. In addition, there are few companies with the corporate structure and culture needed to back up such claims.

From a historical perspective, very few companies have been able to do what Apple is striving to do: remain relevant. While companies like Nike and Disney are often used as models for Apple, in reality, they aren't the best examples. Instead, a company like Sony does a much better job at showing what Apple is trying to avoid: losing sight of the hockey puck and not knowing where it is headed. To accomplish this goal, Apple will need to reinvent itself. If that wasn't difficult enough to do, to expect Wall Street to get behind Apple and such reinvention is overly optimistic.

Management's Plan of Attack

If this divide between AAPL and Apple is expected to continue indefinitely, management doesn't need to just sit by idly. Capital management actions can be positioned to utilize this ongoing divide between how the world looks at AAPL and Apple's quest for the next big thing.

If Apple is all about moving from product to product, there will undoubtedly be periods when Wall Street will turn sour on the company. It will be at these times that Apple should use capital management tools to take advantage of what management deems market dislocations. The key to buying back shares is to do so at a valuation that management thinks the market is incorrectly reaching. When it comes to Apple, the time at which this condition will best be met is when Apple thinks it has found the next big thing while Wall Street continues to doubt. We saw this play out in early 2014 when Tim Cook disclosed to the WSJ that management had been buying a record amount of AAPL shares after reporting a "lackluster" earnings report. Taking a look at the subsequent Apple Watch launch seven months later, it is not difficult to see that management was well aware that Apple Watch would be soon launching, and management felt confident this would be the first new product category under Tim Cook.

If there is one consistency with Wall Street it is that stories change. There will come a time when investors turn more positive on AAPL. Instead of thinking investors finally "got it," in reality, that will be the time when it is even more important to analyze Apple's quest to remain relevant. Estimating future cash flows may be a science, but coming up with products that people love is an art.

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